"Good" China stocks and "Bad" China stocks and how to use them

If China’s stock markets are headed into a rally, it’s time to take a look at what I call Good China stocks and Bad China stocks.

It’s too early, in my opinion, to be sure that we’re going to see one of those explosive 40% to 80% moves off a bottom that China’s equity markets deliver from time to time. We do have a huge drop in the Shanghai Composite Index, which in late September was down 70% from its October 2007 levels. And the index did bounce off of the psychologically important 2000 level on September 26. And the index is up 5.1% from that September 26 low to the October 17 close. (The Shanghai index has trailed Hong Kong’s Hang Seng Index, which is up 11.9% from its low on September 5 through October 17.)

BUT China’s markets have rallied on anticipation—on hope in other words—of more aggressive stimulus measures from the Beijing government in the run up to and the days after the official transfer of power to a new leadership team that is scheduled to take place on November 8 at the 18th Party Congress. That stimulus could be less aggressive than expected or it could be ineffective. (For more on why this stimulus could be way less effective than the last round see my post http://jubakpicks.com/ And it’s quite possible that the 7.4% growth rate for the third quarter, announced on October 18, doesn’t mark the bottom for China’s growth in this cycle.

So we don’t know and won’t know until we see numbers for growth from the fourth quarter (sometime in the first quarter of 2013) or from the first quarter (sometime in the second quarter of 2013.)

If the current stimulus hopes turn into disappointments, I think we’ll see a rally on hope that continues the current move up—until the disappointing data arrive sometime in the fourth quarter of later.

And if the stimulus hopes turn into a real turn in China’s economy, and the third quarter of 2012 does turn out to be the bottom for China’s economic growth rate, then I think we could see a more restrained version (restrained slow growth in Europe, China’s biggest trading partner) of the traditional explosive rally in Shanghai and Hong Kong. Even if that rally is more restrained than usual, it will be worth owning a piece of it. (This, by the way, is my current read. The third quarter numbers showed a decided pick up in growth in September, the last month of the quarter.)

But how? China’s stocks are notoriously volatile and frighteningly opaque. Many investors are rightly afraid that any Chinese stock they buy will turn out to be a fraud based on creative accounting. Certainly there have been enough examples of that—Sino-Forest and Longtop Financial come to mind. And even if the company ultimately turns out not to be a fraud, a short-selling attack on a Chinese company stands a good chance of success because so many Chinese companies are opaque and hard to understand.

In response to that truth about the Chinese market and in order to derive an investing strategy responsive to the unknown potential of what looks to me to be the early stages of a significant rally, I’ve come to think of China’s stocks in two groups. You can call them Bad China stocks and Good China stocks.

Usually when investors talk about “good” and “bad” stocks they mean that “good” stocks are those that they’d buy and “bad” ones are those that they’d shun.

Here I mean something slightly different.

“Bad” China stocks are those that you don’t want to buy on their fundamentals—because the fundamentals are deceptive, misleading, or downright fraudulent and frequently an investor has no hope of telling the truth from the fiction. Oddly enough in the Chinese markets I think these “bad” stocks are frequently those that do best in the early explosive stages of an anticipation rally like the one that seems to be building now.

“Good” China stocks are those that give investors more certainty that the fundamentals are indeed as advertised—even if you still can’t be quite certain. These stocks can lag in the early stages of an anticipation rally but as anticipation of growth turns into real growth, you’d much rather be in this group than holding the early “Bad” rockets.

The usefulness of this strategy lies in being able to judge the difference between “Good” and “Bad” and being able to match that difference to the appropriate stage of the market. You may not, of course, chose to own “Bad” China stocks even during the early stages of a rally—they are volatile and risky, true, although that goes along with their tendency to outperform at this point in the cycle. But you still should learn to recognize the difference even if it’s only so you don’t get sucked into buying that “Bad” China stock when the early owners are starting to sell.

In this post I’ll give you the names of 9 stocks I’d put in these two groups. And I’ll end with some thoughts on how to use them in this potential rally.

“Good” China stocks share a number of characteristics in their business models and in their financial statements.

For example, they often pay dividends.

Why is that important? Not because these companies pay a mouthwatering yield. In fact most dividends in the Chinese market are quite modest. But it’s worth buying dividend-paying stocks in China’s markets because it’s relatively hard to fake a dividend payout. The check either arrives or it doesn’t. And because a company that pays a dividend is probably actually generating cash (although in financial history you can certainly find companies that were borrowing money in order to pay a dividend.) All that means is that a Chinese stock paying a dividend is more likely to be making a profit and showing positive cash flow in truth when the company claims that they’re making a profit and showing positive cash flow. Think of a dividend payout as a proof of concept for the stock.

So I’d put Guangdong Investment (270.HK in Hong Kong) in my “good” stocks category because it pays a 2.95% dividend. That cash comes from the company’s cash flow as Hong Kong’s water utility. If management ever significantly botched up its other business—the company is a major property developer—so that the utility cash flow wasn’t sufficient to cover the dividend, there’s a good likelihood that it would manifest itself in a lowered dividend that would be apparent to all investors.

Café de Coral (341.HK in Hong Kong) gets points for its dividend too (2.82%) yield and the double-check that provides on the company’s operations and financials. The 40-year-old company is the largest fast-food restaurant company in Hong Kong—with 320 restaurants (including Spaghetti House and Super Super Congee and Noodles) in Hong Kong and another 278 overseas. Sales in for the 2012 fiscal year that ended in March climbed 12% while profit of $HK474 million ($61 million) fell by 8% due to higher costs. The company’s final dividend payout of $HK45 a share $5.81, a 74.6% payout ratio, is a good double-check on those numbers. (For example, the dividend has been rising in the last few years—good—but the payout ratio has been climbing too from 67.7% in fiscal 2010 to 74.6% in fiscal 2012—bad since at 74.6% an investor is entitled to wonder if the payout is sustainable.

I’d call Café de Coral a “good” China stock for reasons that go beyond its dividend payout, however. It gets points from me as a “good” China stock because its business is relatively visible—if the company wasn’t making any sales, it’s restaurants would be empty—and because its not a terribly complicated business. An investor can track commodity costs in the commodities market, read about labor costs, and check out price trends by looking at its menus online or dropping by one of its restaurants. (Café de Coral operates the Manchu Wok chain in the United States so you don’t even need to fly to Hong Kong.)The company’s business is one that we all are familiar with and understand. That makes it relatively harder to fake results than if Café de Coral ran a wind power company where sales could be subsidized by local governments—great til the subsidies run out—or where customers are themselves complicated entities that may or may not be actually consuming what they buy. (Please, let me be clear: China is not the only country to have known stock market fraud and management around the world is amazingly inventive at discovering ways to hoodwink investors. One of my favorite stories is that of famed company rescue artist Q.T. Wiles who “turned” around disk drive maker MiniScribe in the 1980s by, among other things, shipping bricks packaged as disk drives. “Sales,” according to the company’s books climbed to $603 million in 1988 from $115 million in 1985.)

A “Good” China stock on this basis is Home Inns and Hotels Management (HMIN). It’s pretty easy to count guests at the company’s motels and claims to 100% occupancy, as the company reported at some motels during the recent peak travel Golden Week holiday are relatively easy to debunk. And like Café de Coral since Home Inns and Hotels is running a mass consumer business the company can’t move the revenue needle by booking one or two or a dozen big sales.

The mere fact that a Chinese company has done a deal with a well-known and, in theory, savvy Western company doesn’t turn it into a “Good” stock. Sophisticated Western investors have been taken for a ride in China just as in the 19th century sophisticated English investors were hoodwinked by U.S. robber barons who bought going railroads and then sold a river of shares until investor were left with nothing but worthless watered stock. But I’d still say that a foreign deal or two does tell you something about a company and its stock. For example, Home Inns and Hotels Management acquired the Motel 168 chain from Morgan Stanley in a 2011 deal that was partially financed by JPMorgan Chase and Credit Suisse. Investors know that Morgan Stanley, JPMorgan Chase and Credit Suisse call did due diligence on Home Inns and Hotels—although, of course, we don’t know how good that due diligence actually was.

Sometimes one of the other of these “Good” stock characteristics is overwhelmingly strong. In other cases a stock gives you a list of “Good” stock characteristics but each one individually is relatively weak. For example, Ping An Insurance (2318.HK in Hong Kong or PNGAY in New York) does pay a dividend—but it’s just 0.79%--and it does have “sophisticated” Western investors such as HSBC (HBC) even if Western banks have a mixed history in their investments in Chinese financial companies.

“Bad” China stocks are often just the reverse image of “Good” China stocks.

For example, I’d put Chinese companies such as China Eastern Airlines (CEA) in the “Bad” stocks group because its major financial relationship isn’t with a Western bank but instead with a state-owned parent company that recently provided a big infusion of cash into what I’d call a nearly bankrupt airline on amazingly generous terms. I think any investor would be rightly suspicious that management will repeat this pattern of over-expansion leading to near bankruptcy over an over again as long as it thinks the parent company will ride to the rescue with government money.

I’d also put a number of industrial companies—in contrast to consumer companies with as Café de Coral or Home Inns—in the “Bad” stocks category when they do business with large state-owned or affiliated customers that may themselves be motivated by something other than market efficiency. For example, local Chinese governments have been buying steel from steel producers to keep the mills (with their big payrolls) open. SunTech Power Holdings (STP) now relies on cash from the Wuxi government to stay in business—even if it can’t sell solar panels at a profit. Aluminum Corp. of China (ACH) was established in 2001 as the flagship of China’s aluminum industry. (The company is now the second largest aluminum producer in the world.) Investors can be certain that acquisitions and decisions about capital spending will be based more on the perceived strategic needs of China than on income statement profit and loss. Jiangxi Copper (358.HK in Hong Kong or JIXAY in New York), another state-owned company and the largest copper producer in China, sells to customers who are themselves frequently state-owned enterprises. Decisions by government officials about how much copper to keep in inventory have more effect on demand at Jiangxi Copper than do global trends in production and consumption.

These same “Bad” stock characteristics aren’t limited to industrial sectors, however. I’d put Hong Kong Exchanges and Clearing (388.HK or HKXCY in New York) into the same group. The company’s June purchase of the London Metal Exchange for a very expensive $2.1 billion had more to do, in my opinion, with the Chinese government’s strategy of building Hong Kong into the dominant financial center in Asia than it did with achieving a profit on that investment in any reasonable time frame.

In my “Good” and “Bad” China stock strategy, an investor wouldn’t always shy away from “Bad” China stocks. In fact, I think that at an early stage in a potential rally—just about where we are now—you want to own a few “Bad” China stocks. At this early stage some of the characteristics that make these “Bad” stocks, particularly their close connection to the government, are actually seen as an advantage by Chinese traders. My favorites here would include Aluminum Corp. of China and Jiangxi Copper, up 25.3% and 24.4%, respectively, from the bottom on September 5 through the close on October 17. I wouldn’t worry about these stocks getting too pricy, as long as nothing disrupts the macro picture—until gains from the bottom are 50% or more. If this turns out to be a rally on hope, you do want to sell these shares on the least sign of disappointment.

As we accumulate more evidence that the government’s stimulus measures are working and that China’s growth rate has bottomed, I’d be looking to move to “Good” stocks. Here my favorites are Home Inns and Hotels Management, a member of my Jubak’s Picks portfolio http://jubakpicks.com/ and Ping An Insurance.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Guangdong Investment, Home Inns and Hotels Management, Hong Kong Exchanges and Clearing, and Ping An Insurance as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/